Net Lease Assets Can Be Safer Than Comparable Bonds: Investment Implications

by: Philip Mause

The history of debt and equity markets since the Crash of 2008 has been a gradual migration of money up the risk curve starting with agency bonds, moving on to investment grade bonds, then on to lower rated bonds, followed by yield oriented equities and ultimately dividend stocks. We start with the assumption that bonds are generally "safer" than equities and, at the end of the day, we may revisit that proposition. However, an analysis of likely risks suggests that net lease assets can be safer than comparable bonds and that, therefore, net lease real estate investment trusts (REITs) may, in certain circumstances, be safer than bond funds.

It is important to compare apples to apples and in the case of net lease REITs this is not impossibly difficult. Net lease REITs generally have long term leases under which the tenant pays utilities, property tax, insurance and maintenance expense, although leases vary in some respects. Thus, landlords are not exposed to the risk of expense inflation and the transaction is, in some respects, more similar to a financing arrangement than a traditional lease. Most net lease REITs disclose the length of lease terms and the percentage credit ratings of their tenants so that an investor can compare a portfolio of net lease assets with a portfolio of bonds issued by a group of companies (or governments) comparable to the net lease tenants. Thus, we can start by examining a hypothetical situation involving a net lease landlord and a bond fund each of which has the same mix of tenant/debtors and the same mix of term duration leases/bonds. My proposition is that given the same term lengths and the same group of tenant/debtors, the net lease landlord may well be in a much better risk position than the creditor.

Default Risk - One important risk that must be taken into consideration is the risk that a tenant/debtor will default on his lease or bond. In the case of large corporations, this kind of default will generally be accompanied by a bankruptcy filing. In that regard, it is important to contemplate the relative positions of landlords and creditors in bankruptcy proceedings. In a typical Chapter 11 bankruptcy, the debtor in possession will go through the outstanding leases and decide to "accept" some and "reject" others. The accepted leases will generally continue in force and the debtor in possession will continue to pay rent which will be treated as an administrative expense and therefore given a high priority as the proceedings continue. The rejected leases will permit the landlord to take over the property and release it (or sell it) to another party. In many cases, the vast majority of leases are accepted and continue in force as if the bankruptcy had never occurred. In contrast, the creditor can face drastic remedies. He can be subject to having his debt interest forcibly converted into equity. If he is an unsecured creditor, he may not even get much equity in the post bankruptcy entity. During the course of the bankruptcy, interest payments can be suspended and may never be paid but will simply be taken into account in determining equity shares. Having participated in the process as an attorney and as a bondholder, I have come to the conclusion that I would much rather be the net lease landlord than a bondholder of an entity filing a chapter 11.

Inflation Risk - Inflation and the consequent higher interest rates can adversely affect both long term landlords and holders of long term bonds. Each situation must be analyzed separately but, as a general matter, long term landlords are better positioned to ride out a period of inflation than are bondholders. There are two reasons for this. The first is that many net leases have an inflation escalator clause which automatically increases rents as at the rate of inflation (in many cases, subject to a cap). Again each situation must be analyzed separately and, unfortunately, many net lease REITs do not provide as much detailed disclosure in this area as would be optimal. However, there is considerable protection especially when contrasted with the zero protection available to a holder of a fixed rate long term bond. The second advantage of net lease landlords in a period of inflation comes into play when the lease or bond matures. When the bond matures, the bondholder gets back the face value of the bond which is worth much less than it had been worth at the beginning of the period of inflation. In contrast, the net lease landlord gets back the property and, if there has been considerable inflation, will likely be able to rent it out at a higher rent going forward.

Caveats. First of all, the above analysis only applies to bonds or bond funds which are comparable in terms of the credit ratings of tenant/debtors and duration terms to net lease assets. Of course, a bond fund made up of short term treasuries has much less risk than a pool of net lease assets with respect to which the tenants have low credit ratings. In practice, it will probably be impossible to find a net lease REIT with exactly the same mix of tenant credit ratings and duration terms as a given bond fund. Investors will have to do careful case by case analysis. There are, as well, other considerations which may affect the relative risks discussed above. A net lease REIT may have higher concentration of risk because of a relatively large percentage of properties leased to a single tenant. In addition, some types of properties may be hard to rent out at the end of a lease. Not all net leases have inflation escalator clauses. The costs of a net lease landlord tend to be higher than the costs of a bondholder because of the need for more administration. Net lease REITs can have more (and, in some cases, less) leverage than bond funds and, of course, this will affect risk. Net lease assets are generally much less liquid than bonds and cannot be sold in increments as easily. Finally, the market may not agree with my analysis and, although in the long term net lease REITs may fare better than bond funds, prices may fluctuate more in the short term due to higher beta. All of these issues must, of course, be examined on a case-by-case basis. Still, the big picture here suggests strongly that, although net lease REITs are equities and are therefore generally considered "riskier" than bonds, in fact the reverse can be true. For the long term investor, net lease REITs have the potential to produce more income with less risk than comparable bond funds.

I have been discussing net lease assets rather than specific net lease REITs and to close the loop, it is important to develop a metric for evaluating stocks in the sector. If I were to analyze each net lease REIT and compare it with each bond fund, this would be a book rather than an article. Instead, I have tried to develop a metric for evaluating net lease REITs which will enable readers to compare the REITs with bond funds having similar yields. My methodology is a bit unusual and I am sure it will elicit some controversy. I generally try to approximate the "private market value" of companies and this involves the use of some metrics that differ from those generally applied. Basically, I compare gross rent with enterprise value to approximate private market value. I use gross rent because most expenses are ultimately borne by the tenant. There are variations in the expenses incurred by landlords and the reimbursements paid by tenants to landlords from quarter to quarter, but this "noise" should tend to even out over a longer term. The Enterprise value is market cap plus net debt and provides a more useful metric because, in a private market transaction, the buyer would have to assume the debt. Enterprise Value/Rent (EV/R) is simply the ratio of enterprise value to annual gross rent. The inverse of the EV/R is the earnings yield on the net lease assets and could be used to compare these assets to a pool of bonds with a similar yield.

We have the advantage of a recent transaction - the proposed acquisition of CapLease (NYSE:LSE) - so that we can compare this multiple for different REITS. This proposed acquisition has been tendered at an EV/R valuation of 15.6 (or an earnings yield of 6.4%). Based on this comparison it appears that a number of REITs are trading well below private market value. Because enterprise value includes debt as well as market cap, share prices could increase significantly were they to trade up to the level implied by the LSE transaction.

With respect to Lexington Realty (NYSE:LXP), Realty Income (NYSE:O), One Liberty Properties (NYSE:OLP), Stag Industrial (NYSE:STAG), Chambers Street (NYSE:CSG), and Agree Realty (NYSE:ADC), I have provided Tuesday's closing price, the current yield, the enterprise value/rent ratio, and the implied common stock price assuming the EV/R went up to 15.6 (the level proposed in the LSE transaction). Rental income is based on annualizing of the most recent quarterly numbers reported to the SEC, enterprise value is based on most recent SEC filings combined with current equity prices as reported by Yahoo Financial, and current yield is based on data from Yahoo Financial and corporate websites.

Price Yield EV/R Implied Price
LXP $11.95 5.1% 12.5 $18.85
O $43.32 5.1% 17.6 -------
OLP $22.59 6.4% 11.2 $36.59
STAG $19.90 6.0% 11.8 $29.40
CSG $8.90 5.6% 18.2 ---------
ADC $13.2 5.6% 13.2 $36.53
Click to enlarge

I included O because it is the largest net lease REIT and offers a kind of useful industry benchmark. This analysis provides a starting point to identify undervalued net lease REITs. REITS with an EV/R below 14 (and, thus, an earnings yield over 7%) are worth further investigation because they may become attractive takeover targets and are likely to be in a position to sustain strong dividends. However, readers should bear several things in mind. Events (such as the acquisition or sale of properties) which occur after the last quarterly reporting date can affect future rental income. In addition, different types of properties can support different valuations (industrial properties may be valued at lower levels and this may explain STAG's valuation). Lease terms and tenant quality may vary from REIT to REIT. Some of the REITs with low valuations are small and likely have higher proportionate administrative expenses and higher risk associated with one large tenant (however, this will not prevent them from being attractive takeover targets).

As noted above, in some circumstances, net lease REITs may have less risk than bond funds. In that regard, some the yields achieved by net lease REITs can be found by bond investors only in the "high yield" and long duration sector. Thus, some net lease REITs may actually have tenants with better credit ratings than the issuers of bonds held by bond funds producing comparable yields (for example, LXP has the federal government as a significant tenant) and, thus, may carry less default risk. As noted above, there is variation among these companies and investors should examine each situation individually. However, there is strong evidence that yield oriented investors who have been migrating into high yield bonds may, in some circumstances, find much better risk/reward prospects in net lease REITs.

I bought LSE well before the acquisition was announced because it appeared to be undervalued, and I am waiting to see whether the takeover offer is increased. I have used this analysis to identify LXP as an attractive investment and have bought some in the past month. I have also used this analysis to better understand iStar Financial (SFI), a hybrid REIT with substantial net lease assets being carried at a book value well below fair market value, as explained in more detail in this article. I am kicking the tires on the others and will probably buy a mix over the summer. At this point LXP and SFI are two of my highest conviction long positions.

Disclosure: I am long LSE, LXP, SFI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.